When a 401k is NOT the Place to Save

For many people, 401k plan contributions are not where all their savings should be going, at least not right now.

You say “Why in the world would you say that?”

Making 401k contributions first equates to building the kitchen in your home before laying the foundation.

401k contributions are ill-advised if done out-of-order or in poor proportion.

You may have heard that 75% of Americans are living paycheck to paycheck. That means they have never laid the foundation for their financial house. Rather than your 401k, start with an emergency fund. Liquid cash , (preferably not that easy for you to get at) is the place to start. For many working people the first time they save real money is for a home down payment. It’s amazing how much you can save if  a really important goal!

Unfortunately, most people buy more house than they can afford. I say that because, after making that down payment and furnishing the home, people end up in a situation where they cannot seem to rebuild their cash account. All their money is going toward their home associated costs and are back to living paycheck to paycheck. BAD PLANNING! Fire the builder!    How Your Next Home Purchase Can Make or Break You

Your financial foundation is your liquid cash fund and insurance that covers your most important assets. Now that you have your home, build up cash again and make sure you have insured your property, and against loss of income from disability, death or major health issues. This is the prudent way to build your financial life. How long could you get by if you lost your job/income? Most people who do save would only have their 401k or IRA’s to tap into. Bad planning!

Once you have built your financial foundation, the kitchen (your 401k) is an appropriate place to start adding to. It’s not the only place, as there are other rooms in the house and other needs along the way that you will want to take care of.  For example, if you want to send your kids to private schools or help them with college, then the 401k is not the place to save. If you want to be able to pay for a wedding, a home improvement or be financially independent prior to age 59 1/2, a 401k is not the place to save.

You can usually borrow from your 401k if you are in a pinch, but that is seldom in your best interest. Taking a loan from your 401(k) does come with risks

Building your financial plan is a multi faceted as your home design. You have a finite amount of money (after-tax income) to disburse between what you spend and what you save. You need to decide where to allocate the money your savings. Just like if you were designing your home, you need to prioritize where you want to allocate your money. For some, paying for their kid’s education is at the top of the list. If that’s the case, a 529 College Savings Plan is going to get a good chunk of your savings. If you want to design your financial house around being financially independent in your mid 50’s than a combination of investment accounts outside of your 401k and your 401k or IRA’s will get the lion’s share of your savings. In this case, you might also be well served to be funding a Health Savings Account as it gives people even better tax benefits than a 401k. Why Health Savings Accounts are Fantastic for Retirement!

Just like there is never a good reason to build anything other than your home foundation first and keep it rock solid, there is never a good reason not to build and maintain your financial foundation. Therefore, you need to be sure to keep your cash, insurance plans and taxable investment plans growing as your income grows.

Have you ever looked at your net worth?

What is it, not counting your home equity and retirement accounts (IRA & 401k)?

Is it embarrassing low? If so, you’re not alone.

It’s generally a good thing to have money in retirement accounts, but it would be a good idea to cut back and re allocate some of that money toward cash, taxable investments and keeping your insurance up to date. As I have written about before, having more liquid cash makes it possible to have higher property and health insurance deductibles saving you premium money every year.

In summary this is a prudent order for building your financial house:

1. Build your liquid cash account
2. Insure your income and property
3. After buying your home, rebuild your liquid cash and update your insurance to adequately reflect your new property and income.
4. Prioritize your pre and post retirement goals and begin dividing your savings toward accomplishing those goals.
5. As your income grows, continue to increase all the areas of your financial plan/house to reflect your financial goals.

Notice that adding to your 401k is only one part (albeit important part) of your financial plan. There are arguments against putting money into a Traditional 401k at all as the future tax burden may end up devastating the value. A Roth 401k maybe a better option or some combination. If your employer matches your contribution it sure makes sense to take advantage of the match.

Some people would rather pay tax on their investment gains at the current low tax rates rather than unknown future tax rates. when they pull money out of their 401k or IRA. Your IRA or 401k Balance is Not all Your’s

In either case, make sure to build your financial house like you would your home, from the bottom up. Don’t start with the kitchen(401k).

I understand most people have little financial discipline and spend everything that makes it into their checking account which makes the 401k attractive since they never see the money. For those people, I suggest creating  automatic investment plans that are treated like your most important monthly bills. You pay your mortgage, auto, cable and cell bill every month, why not pay yourself to start accumulating money outside of your 401k to help reach your other non-retirement goals?

Please feel free to share your thoughts, especially if you believe most people have large net worth’s outside of their home equity and 401k & IRA’s.

Video Why NOT to Save in a 401k